1 Market Efficiency and Performance Evaluation Global Financial Management Campbell R. Harvey Fuqua School of Business Duke University

2 Overview l Market Efficiency »Theory of efficient markets »Types of market efficiency »Evidence »Implications l Measuring Mutual Fund Performance »Performance measures

3 The Net Present Value Rule Investment Projects Primary Market Secondary Market NPV of project NPV of financing NPV of share purchase PV cash inflows Money raised Value of shares Initial Investment Value of liability Price of shares = = = Competitive Advantage Competition in Capital Markets NPV of projects can be positive NPV of transactions is zeroPrices are "fair"

4 Three Forms of Market Efficiency Prices reflect all information from past prices Prices reflect all publicly available information Prices reflect all relevant available information Technical Analysis is valueless Fundamental Analysis is unprofitable Insider Trading is unprofitable Weak FormSemi-strong Form Strong Form

5 Weak Form Efficiency: Tests A market is weak form efficient if current prices reflect all information contained in past prices and price movements. Implications »Past prices cannot predict price movements in the future. »Trading rules based on technical analysis cannot yield superior returns. Tests »Tests of correlation of prices. »Tests of trading rules.

6 Head and Shoulders Pattern Stock Price Time

7 Bollinger Bands 12/3102/1904/0905/2907/1809/ Price ($) IBM Bollinger Bands

8 Studies on the Correlation of Markets Elton/Gruber, 15.2, p. 409

9 Weak Form: Summary Evidence in favor Implications: l Technical rules are useless. l If the price of a stock has just gone up or down, then it does not follow that it will go up or down in the future. Reason: l If technical rules worked, everyone would use them. As a result they would not work anymore. This does not imply: l Prices are “ uncaused ”. l Markets do not behave according to rules. l Investors are incompetent.

10 Semi-Strong Form Efficiency A market is semi-strong form efficient if all publicly available information is reflected in market prices. Implications: l Market reacts to information about companies ’ fundamentals »Macroeconomic news. »News on earnings. l Price adjustments are fast and appropriate: no systematic under/overshooting after announcement. Tests: l Event studies of price reactions to news announcements. l Tests of asset pricing models »Joint hypothesis problem

11 Semi-Strong Form Evidence Event Studies l Earnings announcements. l Dividend announcements. l Leading indicators. l Stock splits. l Accounting changes. l Mergers and acquisitions. l Corporate reconstructions. l Block sales. l Rights issues. l Share tips.

12 Macroeconomic Announcements TimeContent of Annoucement 9.15 amIndustrial Production Capacity Utilization am Business Inventories Construction Spending Factory Inventories NAPM Survey New Single-Family Home Sales Personal Income 2.00 pmFederal Budget no fixed time: Instalment Credit TimeContent of Annoucement 8.30 amConsumer Price Index Durable Goods Orders Employment Gross National Product Housing Starts Merchandise Trade Deficit Leading Indicators Producer Price Index Retail Sales

13 Reaction to Macroeconomic Announcements Question » How quickly do markets absorb information? Is the reaction appropriate? Method »Investigate reaction of futures markets on Treasury bonds, dollar and deutche marks traded on CBOT and CME. Results »Almost all the price adjustment takes place in the first minute after the announcement (eg for –CPI between 8.30 and »Later adjustments cannot be predicted from earlier reactions –No systematic over or underreaction; »No profitable trading on news.

14 Semi-Strong Form Conclusions Evidence l Unbiased evaluation by investors. l Pre-announcement information leakage. l Rapid adjustment to new information. Implications l Fundamental analysis is valueless –Unless it is original, or it incorporates private information. l Check if price has already moved –If not, must be able to act fast!

15 Strong Form Efficiency A market is strong form efficient if all relevant information (public or private) is reflected in market prices. Implications: l Analysts ’ knowledge doesn ’ t help. l No profits from insider trading. Tests: l Profitability of trading on inside information. l Performance of fund managers.

16 Strong Form Evidence l Fund managers ’ peformance: »Mutual funds »Pension funds l Specialists and insiders »Market makers »Corporate officers l Analysts ’ skills »Advisory services »Internal research »Transactions analysis * Analyze mutual fund performance –Implications for semi-strong form efficiency

17 Mutual Fund Styles l Aggressive Growth l Growth l Growth-Income l Income-Growth l Balanced l Income

18 Style and Beta Risk

19 Style and Volatility

20 Style and Average Returns

21 Jensen ’ s Alpha l From the CAPM: l Any expectation can be written as a realized value plus a shock: l Check intercept of the regression model: If fund managers have no additional information we should have:

22 Measuring Mutual Fund Performance Return of Fund Beta 1.0

23 Historical Performance of Mutual Funds

24 Distribution of Alphas

25 Distribution of t-Statistics

26 Portfolio Manager Ability Stock Picking l Stock-picking ability: Can the manager identify which stocks will outperform the market or the industry?

27 Portfolio Manager Ability Market-Timing l Market-timing ability: Can the manager identify turning points between bull and bear markets?

28 Perfect Market-Timing Ability

29 Sharpe Ratios l Idea: use the Capital Market Line »If markets are efficient and CAPM holds, return/risk ratio should be the same for all assets l The Sharpe Ratio is the ratio of excess returns to volatility: l Compare the Sharpe Ratio for a particular fund to that of the market (or appropriate benchmark):

30 Ex-Post Sharpe Ratios

31 The Treynor Measure l Idea: use the security market line: »If markets are efficient and CAPM holds, all assets should lie on SML l The Treynor Measure is the ratio of excess returns to systematic risk: l Compare the Yreynor Measure for a particular fund to that of the market (or appropriate benchmark):

32  i E[r i ] SM L r f AB C XY Z M Ex post Treynor index higher than the market Ex post Treynor index lower than the market The Treynor Measure

33 Graham-Harvey Measures l Create a portfolio of S&P500 futures contracts and a money market account that matches the volatility of the particular mutual fund. l Lever the mutual fund volatility to match the S&P500 futures volatility by borrowing or lending. l In each case, compare the returns of the two portfolios.

34 Graham-Harvey Measure

35 Mutual Fund Performance: New Evidence Issue »Investigate forecasting ability of individual managers: “ hot ” hands and “ icy ” hands in stock picking. Test »Does the past performance of a fund predict its future performance: correlation between returns. Results »Underperformance is more persistent than outperformance of the market. »Past return data help to predict the future relative performance of the fund. »Even funds with “ hot hands ” do only marginally better than the market. Conclusion »Invest in index funds, not in actively managed funds. Source: Hendricks et. al. (1993)

36 Performance Persistence

37 Investment Newsletter Performance l Graham and Harvey (1995) study the performance of recommendations of 200 investment newsletters. l Given the evidence on market efficiency, what should we expect? l Even if the newsletter writers have inside information - should we expect to make money by following their recommendations?

38 Performance of All Newsletters

39 Performance of Long-Lived Newsletters

40 Ability to Time Bull Markets 0%10%20%30%40%50%60%70% -30% -20% -10% 0% 10% 20% Percent of letters which increased weights in each month Performance of Newsletter Strategies Graham and Harvey (1995) Fitted Regression Line Monthly S&P500 Return

41 Ability to Time Bear Markets

42 Implications of Market Efficiency There Are No Money Machines Hence: l Don ’ t pay a premium for acquisitions unless you can add value. l Don ’ t use the capital structure to speculate on market movements: »international borrowing to speculate on currencies. »Debt structure, swaps, and timing to speculate on interest rates. l Don ’ t manipulate accounts to boost earnings.

43 Implications of Market Efficiency Trust Market Prices Hence: l Treat market prices as values; assume price changes reflect information or the value of management actions. l Use the market ’ s free forecasts ’ to value projects using market currency and interest rate forecasts.